The analysisof frequent adjustments of legal depositreserve ratio of People’s Bank of China

Abstract: In China， there are three effective weapons of central bank’s monetary policy namely open market operations， discount lending and reserve deposit requirement.According to history record， PBOC has a preference to use reserve deposit requirement to achieve the desired economic goal. Reserve deposit requirement system plays a crucial role in controlling the volume of monetary credit and adjusting liquidity and interest rate of monetary market. Since 2008， due to the unsteady economic status， the legal deposit reserve ratio has been adjusted for 25 times. An thorough research to the reasons for such frequent adjustment and its effects is highly needed.

Key words: PBOCmonetary policy legal deposit reserve ratio frequent adjustment

As an effective tool for managing risk， the legal deposit reserve system was originated to meet the needs of commercial bank payment and settlement. With the constant development， it has become an important monetary policy. The mechanism of this policy can be described as follow:

Stimulate (suppress) economy →Increase (decrease) money supply →Reduce (raise) legal deposit reserve ratio→Reserve of bank increase (decrease) →Bank loansexpansion (contraction)→Larger monetary multiplier (smaller) →Money supply increases (decreases) →Market interest rate decreases (increases) →Investment and consumption increase (decrease)

The obvious drawback shown above indicates that adjusting the requirements may cause the immediate liquidity problems， especially for the small-scale bankswith inadequate excess reserves. Adjusting the requirements may cause a slump of reserves and then affect its normal operation. It may be very blunt， however，PBOC regards it as the initial monetary tool to regulate China’s economy.The essence of this tool will be explained after showing the graph of the adjustments of legal deposit reserve ratio from 2008 to 2011.

Since 2008， the legal deposit reserve ratio has been adjusted for 25 times， besides this， in the year of 2011， People’s Bank of China raised the rate for 6 times， this rare and astonishing phenomenon is mainly caused by three reasons.

Firstly， the excessive liquidity is the trigger of such frequent adjustments of the ratio inrecent years. The liquidity almost grows linearly from about 67trillion yen of 2009 to more than 93trillion yen of 2011 and the foreign exchange reserve is extremely high in the last three years. Part of the reason lies in the financial crisis in 2008， which is resulted from the subprimecrisis of USA，the economy was badly influenced all over the world. Consumers and investors lacked confidence to consume and invest. In America， to stimulate people to invest and consume， the Federal Reserve adopted the “Quantitative easing”， which caused that the money supply of China increased passively. Furthermore， with the appreciation of the RMB in recent years， a lot of speculators found opportunities to invest in China， therefore， tons of money flowed into China’s market and thus contributed to China’s excessive liquidity. In addition， Double Surplus of International Trade resulted in excess liquidity as well. After global financial crisis， the problem of excess liquidity becomes serious， leading a high inflation in domestic， the CPI of 2010 had a growth rate of 25%comparing with that in last year. As a consequence， stabilizingthe price is the target of China’s government at present， it needs to be solved urgently. Only the use of legal deposit reserve ratio has the direct and rapid effect with lower cost.

Secondly， the limitation and ineffectiveness ofthe other two monetary tools lead to the frequent adjustments of this ratio， which are open market operation and discount lending.

Open market operation

In China， the government bond market is not mature and the scale is still small. Even though the PBOC purchases the government bond， the limited amount cannot write-off the increase of money supply. As a result， the Central Bank Bill has gradually become the major tool of open market operation. Until the maturity date of Central Bank Bill it will release a huge sum of liquidity to the market and then cause a supply

shock to the money market.

Discount lending

The PBOC plays a passive role in discount lending， because the commercial banks have theinitiative. In the caseif commercial banks have adequate money and borrow no money from the PBOC. This tool will turn out to be non-useful.

Therefore， People’s Bank of China chooses to use the legal deposit reserve ratio to control the money supply andmoderate inflation， compared to the other two monetary tolls legal deposit reserve ratio is more effective and less costly

Last but not least， in recent years， there have been a progressively overheated investment in fixed assets of China， according to the statistics， the average growth rate of fixed assets investment is above 25%， and in 2009 the growth rate even reached 30.1%. In the past few years， interest rate came to a history high point and RMB appreciated under the pressure the international trade and political reasons and the further increase have brought in quantities of hot money investing in real estate properties and other fixed assets， leading to a large bubble in the fixed assets. However， the burst of the bubble will heavily hamper the development of China’s economy and definitely will result in serious consequences in many aspects of China. Taken all the factors into consideration， it is rational for PBOC to use legal deposit reserve ratio frequently in the past.

In conclusion， we have found out the reasons behind the high frequency of adjusting the legal deposit reserve ratio ， but it should be noticed that this monetary tool is too blunt and it will lead to a hard landing of China’s economy. In order to accelerate the economic growth steadily and healthily， our government should take effective measures to expand the size of the government bond market and speed up the marketization of interest rate. Only achieve these aims can People’s Bank of China use various monetary tools to adjust the money supply effectively and boost economic growth rapidly.

Reference :

[1]http://mac.hexun.com/Default.shtml?id=A414Y

[2]Michael Geiger April 2006: Monetary Policy in China(1994-2004):

Targets， Instruments and their Effectiveness